Why do people rebalance their portfolios?
I've never rebalanced my portfolio. Because of this, I'm slowly acquiring more stocks through the years, but I'm making more money. Why does one rebalance other than if they can't stomach the risk? I know the rebalance theory is to sell the overflow when prices are high and buy when prices are low. Is this the only reason people rebalance? To me, it doesn't seem as profitable as acquiring more stocks.
Rebalancing is a risk tool. When you establish an asset allocation that meets your objectives then rebalancing will force you to add risk when prices are low and will force you to trim back risk when prices have outpaced other assets within your diversified portfolio.
Without rebalancing your portfolio will continue to get concentrated in risk assets and will force your hand at some point in time to make a decision on when to reduce risk. That also makes the assumption that your risk assets always go up and never go down. People that did not rebalance the portfolios in the late 90s learned a hard lesson. So did those that got overly concentrated in real estate prior to 2007.
Acquiring more stocks suggests that you have more money to invest.
Rebalancing, is a repositioning of an existing portfolio to bring it back to it's planned asset allocation.
For instance assume you wanted a portfolio or 50% Growth Investments and 50% Value Investments. If you left your portfolio alone over the past three years, you've likely seen your overall asset allocation shift much more in favor of Growth. Thus your portfolio might now be 65% Growth and 35% Value. If you're of the belief that markets ulitmately revert to a norm, it would make rational rebalancing sense to SELL HIGH (that mean's give up 15% of your Growth Portfolio) and BUY LOW (Reposition the money from the sale of Growth investments into your Value positions).
Admittedly, a rebalancing strategy works a lot easier with mutual funds than it does with stocks.
You have already had several good responses to your questions. However, I am going to address each of your statements to help you make the connections.
"I have never rebalanced my portfolio" When you established your portfolio, you decided on what was a good allocation mix for yourself. For instance, 60% stocks and 40% bonds. As the stocks outperform the bonds, that shifts to 65/35, then 70/30, then 75/25. So, was the 60/40 mix really better for you? And is the 75/25 mix what you really want for yourself? If you do not rebalance back to 60/40, you are effectively arguing with yourself regarding what is really best for you, or determining that your "best" allocation strategy has changed. Then I would ask why and how you think that has changed and force an understanding of where your hands-off practice had taken you.
"I am slowly acquiring more stocks through the years, but I am making more money." It sounds like you are receiving dividends and letting them reinvest. That is good. But you say you are makig more money and I ask "More than compared to what?" How do you know you are maximizing your overall returns if you are not considering rebalancing? For instance, if you have 60% value stocks and 40% growth stocks. The value stocks will pay dividends and, when reinvested, result in more shares owned. However, the growth stocks may not pay dividends and the number of shares may not increase, but the value of each share you do own may increase. Depending on the overall performance of each holding, again you may get out of balance and be in conflict with what you initially decided was an appropriate allocation for yourself. If you end up at 75/25, then while you are getting more dividends and shares on the value stocks, you are loosing out on growth benefits of 15% of your protfolio. The 15% being the part of your portfolio that morphed over to the value segment.
"Why does one rebalance other than if they can't stomach the risk?" Risk is relative. You decide how much risk you want when you establish your portfolio. So, yes, if your risk tolerance has remained consistant, but your portfolio has shifted, then you need to get back to the original allocation. Keep in mind that portfolio allocation and risk are not only about opportunities for gains, but also protection against losses. If you are 60/40 stocks/bonds, and stocks drop, your losses are likely to be more tempered by the stronger defensive bond position than a 75/25 portfolio would provide.
"I know the rebalance theory is to sell the overflow when prices are high and buy when prices are low." I think you are confusing taking profits with rebalancing. It is often the case that both happen simultaineously, but one can happen without the other. Your portfolio may actually get out of balance due to losses in one segment, at which time a good case could be made for rebalancing without necessarily waiting for a high to sell, but sell anyway and buy low and rebalance. Or you may want to take profits from a particular stock that has peaked and buy another that is low, but if both are in the same asset category, this would not change the asset class allocation of your portfolio, and not bring you back to where you need to be, if out of balance.
In order to compare the relative profitabiltiy of different strategies, you have to actually run scenarios under each condition to see the results. I suggest you work with a fee-only investment advisor who can work through this with you and help make the most of putting your money to work for you. All the best.
You hit on the two primary reasons that re-balancing is typically used as part of an investment strategy. 1) To ensure that the overall "risk" of the portfolio remains as it was intended. As you suggested, your portfolio has become riskier over the years as stocks have outperformed your less risky investments. Typically, when developing a portfolio you take a number of factors into consideration when developing your allocation. How long until you'll need the funds? For what purposes? Are taxes a concern? How do you handle volatility? In order to maintain the goal of the portfolio and original risk parameters, investors will rebalance.
2) You rebalance to help take the emotional part of investing out of the equation. It can force you to sell well-performing investments at a high and purchase more share of worse performing investments at a low. If you have this strategy in place, you're not necessarily making decisions on a whim or based on emotion and how a particular investment or the market has performed recently.
In your case, if you're comfortable with the volatility of stocks and don't necessarily need the funds anytime soon, it seems that's a better allocation for your in the first place. However, even with individual stocks, you'll have well-performing ones and ones that don't perform particularly well over time. Rebalancing principles can still be applied here.
Any stock portfolio has two components of risk: market risk and unique risk. You can't avoid market risk. Unique risk is the amount of deviation your portfolio would experience (from the market average) due to the action of a single holding. If that holding rose tenfold, your portfolio would outperform; if it went bankrupt, it would put a hole in your investments. If one holding is unusually large in relation to your portfolio, you are taking more unique risk and that's why people diversify. Advisors rebalance because while outperformance increases their income, underperformance can get them fired.
Obviously, Bill Gates or Mark Zuckerburg didn't get rich by holding a diversified portfolio. If you hold a few large positions you aren't necessarily in danger of a big loss. You just have all your eggs in too few baskets. But if you know the underlying companies and have faith in them as being likely to be many times their current size at some point in the future (as did Bill and Mark) there's nothing inherently wrong with what you are doing. However, to invest this way you ought to be financially sophisticated enough to be able to recognize the pitfalls and act accordingly.
The average investor can't afford an unexpected loss. That's why they trim their winners and use the proceeds to buy holdings that are diversified across industry sectors and asset classes. ("No one ever went broke taking a profit.") I hope your approach continues to benefit you, but you know full well that it might not. So act accordingly.